Transcript:
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Music:
[Intro Music]
Mark Eckerle:
Welcome to this episode of founded in tech. I am your host Mark Eckerle, and today’s show is part of our tech tips series, where I sat down with Dan Krolikowski to talk about qualified small business stock. On today’s episode, we discussed the qualifications for a company’s stock to qualify as qualified small business stock, or QSBS, who is eligible to participate and then tax planning considerations to help get the most benefit from your QSBS. This conversation was very insightful and talking with Dan, a lot of great takeaways, and I hope you enjoyed as well.
Music:
[inaudible]
Mark Eckerle:
Welcome to today’s show. Today, I am joined by a recurring guest, Dan Krolikowski to talk about qualified small business stock. Dan, how are you doing today?
Dan Krolikowski:
Mark, I’m doing great. How about yourself?
Mark Eckerle:
I’m doing good. Doing good.
Dan Krolikowski:
Really appreciate you having me again.
Mark Eckerle:
Yeah. Welcome back. Welcome back to the program. So before we jump into qualified small business stock, why don’t we refresh our listeners a little bit on your background, what you do here Withum, your, your role, your title, et cetera.
Dan Krolikowski:
Yeah, absolutely, Mark. So my name is Dan Krolikowski. I’m the team leader of Withum’s founders and tech executive group. And we really deal with individuals and, and offer them private client services. A lot of the things we specialize in are qualified, small business stock, equity compensation, and other related items.
Mark Eckerle:
Okay. So jumping to the beginning, what is qualified small business stock? Why don’t you give us the definition and what kind of classifies stock as, uh, or company’s stock, small business?
Dan Krolikowski:
Yeah, definitely. It’s one of the hottest, you know, issues right now, Mark. So if everybody doesn’t know what it is, it’s basically C corporation stock, domestic C corporation stock, where you may actually be able to eliminate paying tax on a portion or possibly all of your gain of that stock. So, you know, really briefly that’s what it is.
Mark Eckerle:
Okay. What, what are the qualifications then in order for a company stock to qualify as a, instead of, instead of continuing to say, I’m going to say QSBS.
Dan Krolikowski:
Absolutely. And that’s what everybody calls it. Sometimes you’ll see it called QSBSS. You’ll see it called qualified small business stock. You even hear founder shares and there’s a ton of other names for it too. Um, but basically QSBS and the other requirements besides being from a domestic C corporation at the company level is that there’s a small business requirement for the company. So basically what that means is the QSBS is issued by a domestic C corporation. It’s not a mutual fund. It’s not a real estate investment trust, or a couple other different entities, um, that it can’t be, and that the gross or the gross assets of this company have not exceeded $50 million anytime from inception to the current year of issuance. There’s also an original issuance requirements, which basically means you need to receive it directly in original issuance from the C corporation.
Mark Eckerle:
Which, which of those requirements that you laid out, which one is the most common to trip companies up, or which one should they be most on the lookout for? Is it the 50 million in assets or, or which one would it be?
Dan Krolikowski:
Yeah, definitely. Um, so there’s that, and there’s actually some other requirements too, Mark. Um, one’s an active trader business requirement a little bit. No, all good. All good. So there’s actually an active trader business requirement as well. To qualify as qualified small business stock. The corporation itself actually has to be an active business. So it can’t really be like just a holding company, basically, you know, it’s gotta be doing an operating activity and basically 80% of those assets of the company needed to be used in the operations. And then the last thing is that there’s no significant stock redemption. So a lot of times what you’ll see these companies will check all the boxes to be a qualified small business stock. But what sometimes happen is there’s a significant stock redemptions, um, whether it’s by one shareholder, a few major shareholders. And if that happens, that can actually take the QSBS for everybody after that. So a lot of times, you know, that’s what trips companies up is you have these, these founders and, and everybody that kind of wants to cash out. Um, sometimes if that happens, that could take the QSB status.
Mark Eckerle:
Okay. So by the founders trying to tripping up a little bit there, they can ruin it for everyone involved.
Dan Krolikowski:
Exactly.
Dan Krolikowski:
And, you know, it may not just be the founders. It could be any significant stock redemption. So even a certain group of people, maybe the company’s trying to clean the cap table out or something, that’s just something that is always, should be a consideration.
Mark Eckerle:
Okay. So, so outside of company specifications, um, is there any time commitment behind holding stock in order to qualify for QSBS
Dan Krolikowski:
Yeah. When we’re talking to qualify for QSBS besides, um, the company requirements, the individual, or, you know, other allowable entity that can hold QSBS actually has to hold the stock for five years in order for it to qualify as QSBS when subsequently sold.
Mark Eckerle:
Okay. And that’s from, from date of grant?
Dan Krolikowski:
Actually, no, it would, if it was stock options, it would be from date of exercise. So if it’s just common stock, it would be the date that you received the stock. If it’s not subject to restrictions. If it’s subject to restrictions, it could be when those restrictions lapse, or if it’s subject to vesting, it could be when the stock or option actually vested. So, you know, it’s definitely a huge consideration for people to make, um, in order to get that five years, when do I actually start my holding period?
Mark Eckerle:
Yeah. So, so it’s, it’s AF it’s fully vested or unrestricted stock, essentially.
Dan Krolikowski:
Exactly.
Mark Eckerle:
Gotcha. Okay. And that’s the beginning of the five-year period?
Dan Krolikowski:
Exactly. And just to show you an example, say I’m a listener who has non-qualified stock options, right? Whenever those non quals are granted to them, they’re not, they don’t own, QSBS. They don’t actually own the stock until it’s exercised. So that’s typically how it works in a stock option scenario.
Mark Eckerle:
And do you, cause I could easily see listeners getting tripped up where the five-year period doesn’t kick off until it’s fully vested or unrestricted, because that’s quite a significant time period where maybe they sell the stock or do something else with it. And that five-year period wasn’t fully met. So is that, do you come across that a lot where, where maybe they get to that three or four year mark?
Dan Krolikowski:
All of the time, all the time and you know, there’s other, you know, things to think about whenever you’re selling stock, right? So it may not always be just to get to that five-year holding period, get to the QSBS exemption or else that should be a consideration. If you actually hold stock for over a year under the current tax law, you can get long-term capital gain rates, which are preferential rates. Um, they’re obviously not zero, which could be the case with QSBS but, you know, that’s nothing to laugh about. Um, and then there’s other options if you don’t actually hold QSBS for five years. So, you know, if you’re getting stock in a tax-free reorganization, the gain that you would recognize on the date of that sale, that could actually be QSBS gain. If you were to that, to then hold the new stock that you receive for a total holding period of five years, and then there’s things called 1045 rollovers, where you can actually, um, take the game that you recognize on a sale of stock that’s QSBS, and you haven’t held it for five years. Um, and then you can actually roll those proceeds into a new QSBS and if it meets certain qualifications, you can actually defer paying tax on the gain currently. And then that new stock could possibly be QSBS which would qualify for QSBS exclusion in the future. So there’s definitely a lot of planning, um, that you could do with QSBS if you don’t meet the five-year holding period,
Mark Eckerle:
I was going to say, yeah, you’ve covered a lot there. And planning always comes back to it, but jumping back quickly into that, what would be the, um, that QSBS gain? That’s the difference in the fair value from fully invested and unrestricted stock to what the fair value, fair market value of that stock is today?
Dan Krolikowski:
Yeah, definitely. So anytime you calculate gain on the sale of stock, you’re always going to take the proceeds that you receive now, less whatever basis you have in the stock is. So if you paid anything for the stock, that’s going to add to your basis, um, if you exercise stock options, or if you actually, you know, perform services for that stock and recognized income, so you could have basis in that stock. So typically when you calculate gain in general, you take the proceeds that you receive less your basis. Um, they have in the stock. So if you have that stock for five years, and that’s, QSBS, that’s the gain that you could exclude.
Mark Eckerle:
Okay. And then how does that parlay over? You said it was, I think it was 1045, form 1045. How does that parlay over to that form?
Dan Krolikowski:
Exactly. Definitely.
Mark Eckerle:
So you said roll the gain over, correct?
Dan Krolikowski:
Yeah, exactly. So you would take those proceeds that you’ve had on the sale, and you could roll that into new QSBS if you didn’t meet that five-year holding period, you have to make that roll over within 60 days of the sale, or else it won’t count under 1045, and then you can actually defer paying tax on the gain that you would have recognized on the sale of the old company. Now, the replacement company stock that you have actually will not have basis because you deferred paying tax, you know, originally on the sale of the first company. So your basis is zero and the new company stock, but if you were subsequently to hold that, um, and it qualified as QSBS and the old stock and the new replacement stock, you know, you held it for at least five years total. Um, you could actually then get a QSBS exemption on the gain of the sale of the replacement stock. So that’s typically loosely how 1045 works.
Mark Eckerle:
Okay. But, so, but that would only apply if the stock you sold qualifies as qualified small business stock, and you held it for five years. So if you’re selling after three or four years, that that scenario does not necessarily apply. Correct.
Dan Krolikowski:
So it actually does apply in that scenario. So it would be, if you didn’t hold it for five years. If you held it for five years, you could actually, you could possibly exclude the gain on the sale. So you wouldn’t necessarily need to do a 1045 rollover. So this is strictly for QSBS it isn’t held for five years.
Mark Eckerle:
Gotcha. Okay. That makes sense then. And, and I guess the ultimate question is, is who can hold qualified small business stock? Is it just founders, like you said, founder shares, um, who individually qualifies, is it employees granted a non-qualified stock options that, that exercise them? What would that look like? And who’s eligible to participate.
Dan Krolikowski:
Yeah. So really anybody, any individual can hold qualified, small business stock, and also partnerships. And S-corporation, so, you know, some flow through entities can hold QSBS and then finally estates and trusts can hold QSBS as well.
Mark Eckerle:
Okay. Now, now, jumping over to the tax side of things, the, the exciting side of this conversation, how much, or what percentage of someone’s gain, um, I know we touched on this a little bit where there’s, but you could possibly have write off zero and have no gain or zero tax consequences, but what’s excluded from tax. And what are the inner workings there to be, to kind of, uh, get the most benefit or maximize your tax?
Dan Krolikowski:
Yeah, so it really depends on how much you can exclude based on when you acquire the stock. So if you acquire the stock after September 27th, 2010, you could probably exclude a hundred percent of, you know, your QSBS gain up to $10 million per issuer exemption, um, for accurate acquisitions after February 18th, 2009, through September 27th, 2010, um, 75% of the gain up to $10 million purchase, your exemption can be excluded. And then finally, for acquisitions after August 10th, 1993, through February 17th, 2009, 50% of the gain can be excluded up to the $10 million Perisher exemption. And there’s no QSBS exemption for stock that’s acquired before August 10th, 1993.
Mark Eckerle:
Okay. And if someone were to go through that process, what does that look like on a tax form? What are the forms that this gain is reported on or the exclusions allowed on? What, what does that look like from a reporting side?
Dan Krolikowski:
Yeah, so the schedule D is the summary capital gain schedule, and then the sub schedules to that are form 89, 49. So you would actually report this qualified small business stock exclusion on the 89 49 schedule as an adjustment to the game.
Mark Eckerle:
Gotcha. Okay. Yeah.
Dan Krolikowski:
And then you code a heater, which perfectly fits qualified small business stock. So if you see, you know, a co Q on form 89, 49 with a negative adjustment, you’re taking a QSBS exclusion.
Mark Eckerle:
Okay. So I always ask this question to wrap up with all of our guests, um, in your experience, working with qualified small business, working with, with founders, employees who hold stock, what would you say is a common misstep or something they wish they had known from the beginning? I think the biggest thing here. So I’m going to, I’m going to caveat it with, besides the five-year period and knowing when that begins. Um, because I think that’s obviously the biggest takeaway here. This conversation is knowing when that five-year period starts and when it ends and what qualifies as small business. But, but what would you say outside of that, um, is a common misstep that you think holders of qualified small business stock wish they had known?
Dan Krolikowski:
Yeah. Great question. I think the main thing there is how do you calculate the exclusion that you get per year on your tax return? And there’s actually a calculation that people don’t really, you never really read about it. People never think about it. Everybody just thinks, Hey, I can exclude $10 million of QSBS gain per company, and really under 1202 B, there’s a greater than calculation that you can calculate every year. So you can actually exclude either $10 million per issue or per lifetime or 10 times your basis. So if you, if you exercise stock options, um, you may have a decent amount of basis. So there’s definitely some thought process that gets in there. And you may be able to exclude more than the $10 million approach where lifetime exemption going off, that there’s also ways that you can, you can get additional $10 million Parrish or lifetime exemptions.
Dan Krolikowski:
That’s what we call it stacking. Um, so you can actually gift qualified small business stock. And the recipient of that gift will get a carry over holding period, a carry over basis, and it will still be considered qualified small business stock. So a lot of times what you’ll see, um, and that allowed people to do for income and estate tax planning is they’ll actually gift QSBS to an irrevocable non-grantor trust, which simply means that you’re giving up control. And then the trust is its own taxpayer. And then trust can actually get another $10 million per issue, your lifetime exemption. So, you know, I just want people to, to kind of think outside the box a little bit and not just be so focused on all I can get on this as a $10 million, $10 million exclusion, you know, it could actually be a lot more than the $10 million with the 10 times basis calculation. And then there’s actually ways that you may be able to get additional $10 million per issue exemptions.
Mark Eckerle:
So, so real quick, I know I said that was my last question, but I have two follow ups to that for clarification for purposes. What is form a 1202 B and on top of that, the calculation that you talked about, whether it’s the 10 X of cost basis or not, uh, is this calculation possible for someone to do on their own? Um, do you recommend bringing in professional? Um, I guess it depends on the extensive list, the extensiveness of their, their holdings, but, um, how simple is it that calculation to perform? Uh, obviously you’d want the advice of your tax professional, as well as your you’re reporting this on your tax form, but what does that look like? And, and going back to my earlier question, what is form 1202 B?
Dan Krolikowski:
So there is no form 1202 B. Um, as we talked about, everything’s reported on schedule D 89 49, and then you’re responsible for calculating your own annual QSBS exclusion that you’re going to put on your tax return. Um, 1202 B is simply the code section that calculates what that annual exemption is going to be for you. Um, so we actually help clients all the time with that calculation. Just some tips in general, when you’re trying to think about maximizing that exclusion. A lot of times, what we recommend is that you sell zero basis QSBS first and then subsequently you would sell QSBS with basis. And what that would do it would allow you to maximize your $10 million per issue or exemption for that stock. And then once that runs out, you can then additionally benefit off of 10 times basis. So you can actually get more than that $10 million. And then the other thing to think about is if you have, um, QSBS assets, either 50% excludable, 75% excludable, or a hundred percent excludable, you typically want to sell your hundred percent excludable stock first fall by 75% and 50% in order to maximize that $10 million per share exemption. So there are definitely things that we would help our clients they could.
Mark Eckerle:
Okay. Yeah. As you can clearly tell, I’m not a tax professional. So, so.
Dan Krolikowski:
We still love you, Mark.
Mark Eckerle:
So do you have any other, any tips or tricks? I mean, I think we’re, we’re at the wrap of our conversation and we covered a lot here today. Is there anything else besides working closely with your financial planner and your tax accountant to make sure you’re maximizing this benefit?
Dan Krolikowski:
No, I think it just really figuring out, like, what’s your current situation now, and then going forward, you know, what are you planning for? What are your goals? I mean, 1202, you know, is a great tax savings, but it’s not the only tax saving technique that’s out there that’s available. There’s really nothing else. I mean, the only other thing that I could think about is, is just maximizing your overall income tax and estate planning together. QSBS, if right now, under current tax law, if, if you were to die with, um, appreciated stocks in your estate, you actually get a step up in basis right now. So, you know, there may be some kind of estate tax planning considerations that you could have even before year end this year, where you can say, Hey, I’m actually going to try to use my lifetime exemption gift.
Dan Krolikowski:
QSBS to get these additional $10 million exclusions, get it out of my estate. So, you know, then my heirs can now benefit when they sell this QSBS they won’t pay any tax on it, versus if I were to die with it in my estate. Now it’s, the basis going to be equal to the fair market value. So unless there’s any other appreciation for when my heirs inherited, they’re not going to get to benefit from that QSBS exemption. So, you know, that may be one other thing to think about as people are thinking about estate planning and income tax planning at the end of the year.
Mark Eckerle:
And for, for gifting. Um, is there any cap on that? What if I own, uh, I have my hands in multiple pots and I have multiple QSBS from multiple companies. Is there a cap, a dollar figure cap on that? Or can I get that as many ways as possible?
Dan Krolikowski:
Yeah. So the way estate taxes work currently, and I stress currently, um, depending on, you know, what the future holds is that a person in 2020, um, can give 11, 11.58 million dollars away without any estate tax consequences. If their estate is, is greater than that, there’s a 40% tax on their state. Um, so really, you know, depending on just looking at like, whatever your total holdings are and just making sure that as part of your overall plan.
Mark Eckerle:
Okay. No, yeah, that, that makes sense to me and, and understanding it all comes back to financial planning. Um, there’s a lot that goes in here. I think that the biggest takeaway, like we’ll continue to drive it home is just understanding your, your five years that what qualifies as QSBS and what doesn’t, and making sure that you’re, you’re striking at the right time.
Dan Krolikowski:
Exactly. And really, you know, it’s, uh, there, there, it’s one of the biggest, um, income tax benefits that we have in the tax code right now. Um, so you’ll see that everybody’s actually setting up these companies to try to benefit from this code section. So I think if you are starting a company to, um, at the end of the day, you may want to look at making sure that it meets its code section.
Mark Eckerle:
Great. Well, that wraps up our discussion today on qualified small business stock. Thank you, Dan, for joining us again. If you’d like to learn more, please visit Withum.com for more information, and we have a specific founders team page for you to check out. Thank you for joining us. Thank you. If you liked it and want to hear more, you can follow us and subscribe, and we’ll see you next time on founded in tech.
